Tuesday, January 17, 2012

Filling a hole or priming the pump?

Who knew that neoclassical economists had something perspicacious to add to the stimulus debate? Steve Williamson sends me to this AEA talk by Jim Bullard of the St. Louis Fed. The presentation is mostly a rebuttal of the common liquidity-trap arguments for stimulus, but at the end, there was this one really interesting slide:

An alternative theory

An alternative theory is much less studied but closer to the rhetoric on fiscal policy effectiveness.

Suppose two regimes exist, one involving high growth and the other involving low growth.

Heavy government borrowing might signal that the high growth regime is likely; this might then influence private sector expectations and private sector decisions.

The high growth equilibrium could be encouraged as a self-fulfilling prophecy.

However, if government spending is viewed as wasteful, the private sector could coordinate on low growth.

Williamson adds:

As Bullard states, the type of coordination failure that some Keynesians appear to have in mind - self-fulfilling beliefs about the future driven by fiscal policy - has not really been formally studied.

Verrrrrrry interesting. Bullard is saying "All you Keynesians are bending over backward trying to make stimulus all about countering a shock to Aggregate Demand, when actually you have a mental model of an economy riddled with coordination failures and multiple equilibria, where stimulus is all about expectations."

I think he might be right about that.

To me it seems obvious that a recession is a coordination failure. There are all these unused workers sitting around wishing they had jobs, and all this capital sitting around not being used! Even if you are believe a "recalculation" story, in which recessions are the sluggish response of a complex system to a structural shock, there is no guarantee that the adjustment proceeds at the fastest possible rate. Basically, unused capacity means we are not making as much stuff as we could be.

Now, the commonly used Keynesian models do involve some kind of coordination failure. In the classic Keynesian Cross model, buyers and sellers fail to coordinate their plans, resulting in an inefficient buildup of inventories. In modern New Keynesian models, sellers (including workers) fail to coordinate their price changes, resulting in too-high wages and unemployment. In both of these models, fiscal stimulus works - if it works - by "filling the hole" in aggregate demand.

But the thing is, both of these models are short-term models. The Keynesian Cross offers only a very short window for stimulus to work, since inventories typically get run down in a few months. In New Keynesian models, prices adjust over a period of perhaps a couple years. If Congress doesn't "fill the hole" in AD, the hole will fill itself. That is because both of these models are single-equilibrium models - for a given fiscal policy, there is one level of output and prices to which the economy must move.

In a world with multiple equilibria, however, there is no such certainty. In a world of multiple equilibria, different initial conditions can have devastating and persistent effects on the economy. That is a world of lost decades, debt overhangs, self-fulfilling pessimism, and "sunspots." In that world, fiscal policy may not be important only in the short term, but in the medium or even long term. That is scary, given how uncertain and slow and inefficient the political process can be. But it is also optimistic in a way, since a relatively small stimulus might be able to nudge the economy from a bad equilibrium to a good one, thus "priming the pump" rather than "filling the hole".

Bullard and Williamson say that this is the type of model that modern supporters of fiscal stimulus really have in mind. I don't know to what degree that is true. It certainly is true that Keynesians and others have spent some time and effort trying to construct multiple-equilibrium theories to explain why fiscal policy seems to make a difference. And it certainly is true that the often-used metaphor of "priming the pump" invokes a multiple-equilibrium situation. For my part, I find it much easier to believe in a world of multiple equilibria, for reasons both theoretical and anecdotal. I even have some conjectures about what kind of equilibria those might be, though that is the subject for another post.

So should we be focusing on building multiple-equilibrium models in order to evaluate fiscal policy? In practice, it's hellishly hard to make those models both tractable and predictive (especially when forced to work in a clunky DSGE framework!). That is probably why stimulus advocates have used New Keynesian models with liquidity traps to make their case in intellectual circles. But progress is being made on the multiple-equilibrium front - for an example, see this recent paper by Angeletos and La'O (about which I also intend to blog more).(Update: Whoops! Wrong paper...thanks to Steve Williamson in the comments for pointing that out!). For some examples, see various work by Roger Farmer. I say that this is a very important direction for research.

It also means that we shouldn't assume that fiscal policy questions will simply become moot as time goes on. Depending on the type of equilibria the economy faces, stimulus may not only be a policy for the short term. It's interesting that neoclassical economists are the ones bringing attention to this idea.

Update: In the comments, Roger Farmer adds so much information about his work on multiple-equilibrium coordination-failure models that his comment is substantially more interesting than my entire blog post. Hence, I will post the comment here in its entirety:

Thanks for drawing attention to co-ordination failure models Noah. Let me clarify a couple of points about how my views differ from those of the new-Keynesians.

First; as you point out in your post, I have been working on a new generation of co-ordination failure models in which a high unemployment equilibrium can persist forever. The clearest exposition of these models is here

I call these, second generation coordination failure models. They are different from the first generation models that Stephen refers to (for example, Farmer-Guo (1994) JET). First generation co-ordination failure models have multiple non-stationary equilibrium paths all converging to the same steady state. Second generation models have multiple steady state equilibria. This is a significant difference since first generation models, like new-Keynesian and classical models, cannot account for persistent high unemployment. Second generation models can.

Second; Steve is correct that I am reluctant to support large fiscal stimulus programs. I have written two papers on the role of fiscal stimulus in second-generation co-ordination failure models, one in an overlapping generations model here

In both of these models, a fiscal stimulus will decrease unemployment. But if confidence remains low, the fix will be temporary. In both models, the fiscal stimulus reduces welfare because it crowds out private consumption.

Recall that in Keynesian models, increased government expenditure is supposed to "crowd in" private consumption. That is the whole idea behind the consumption-income multiplier. My reading of the evidence is that "crowding in" (an increase in consumption caused by an increase in government purchases) is not supported by the data.

If fiscal stimulus is to have a permanent effect in the models I work with, it must work through a non-economic mechanism. One channel would be a temporary boost to employment that restores the confidence of the private sector by influencing market psychology: A confidence booster. That is a possibility. But I think it is implausible that increased government expenditure will have that effect.

My reading of the evidence is that consumption depends primarily on wealth rather than income. That was the lesson of work by Ando and Modigliani, Modigliani, and Friedman in the 1950s. It is for that reason that I support interventions in the asset markets that try to jump-start the economy and reduce unemployment by boosting private wealth. That, in my view, is what quantitative easing has done.

Isn't the real point that you are building equilibrium models but the real world is about individual agents reacting to their individual situation - and that reaction doesn't necessarily move the world towards equilibrium (if such a thing exists). Please, please, please, consider building proper dynamic models.

Also, I'm with 'reason'. The whole concept of equilibrium models is a massive intellectual failure.

Economies are dynamic dis-equilibrium organisms. All life is.

IS-LM liquidity trap theory is based on flawed assumptions, but is an ok approximation of a balance sheet recession in its policy prescriptions.

But they key thing is that you don't need IS-LM to understand a balance sheet recession. You just need to understand the dynamics of credit creation and destruction by individuals borrowing and repaying loans.

The stock of credit is a key determinant of the flow of transactions in the economy. That's why credit growth drives GDP growth and aggregate demand.

New Keynesian DSGE models ARE dynamic (hint, what does the D in DSGE stand for?) and they ARE about describing disequilibrium, i.e. output that is persistently deviating from its 'natural' or 'flexprice' level, as well as describing the saddle paths they may follow.

A couple of thoughts. First, I don't think your characterization of the Keynesian cross is quite correct. When you speak of a buildup of inventories, I guess you mean when Y < E. Obviously, this process comes to an end eventually, but that doesn't imply employment will recover. Instead you get stuck in a new equilibrium with lower Y.

As for New Keynesian models, Paul Krugman seems to think he has demonstrated that the economy won't recover if in a liquidity trap. He thinks expectations of inflation are crucial in such circumstances. I'm not sure if he's right, but I'd trust him over Steven Williamson any day.

Exactly, the Keynesian cross tells us that as aggregate demand changes, there must be a change in the static equilibrium where Y=E. So if E falls we move to a new equilibrium with lower Y, and there is no reason why the economy should return to its previous output, unless E increases.

On to that comparative static analysis, people have added a dynamic story about inventories to explain how you reach the new equilibrium, but that's a sideshow really.

"Bullard and Williamson say that this is the type of model that modern supporters of fiscal stimulus really have in mind."

That's not quite right, at least speaking for myself. Krugman has made it quite clear that he is an IS/LM guy, though occasionally you can read multiple equilibrium reasoning into what he says. I don't think you'll find multiple equilibrium in anything that DeLong or Christina Romer talk about. On the other hand, I was talking to Roger Farmer (clearly a multiple equilibrium Keynesian) at the ASSA meetings, and he is definitely not a supporter of fiscal stimulus.

"...it's hellishly hard to make those models both tractable and predictive..."

I'm not sure about the tractable part. Look at Farmer/Guo (1994) JET. The predictive part is certainly a problem. By definition, a multiple equilibrium model has problems with prediction.

Angeletos/LaO: I don't think that's the solution to your problem. I see their model as indistinguishable from Prescott's. Note in particular that equilibrium is unique.

If you have a non-linear function of multiple variables you can have multiple local extrema. Classic first order (linear) models do not show such behavior because they cannot. It would be interesting to see a plausible model that actually exhibited multiple STABLE equilibria.

The truth is probably that we are all Bayesians constantly updating our models and predictions on basis of current events. If we predict the economy will do badly then it will. Keynesian stimulus works (1) by generating a self fulfilling illusion of relative prosperity and (2) simply by being one half of a counter cyclical policy (the politicians always forget the other half).

Thanks for drawing attention to co-ordination failure models Noah. Let me clarify a couple of points about how my views differ from those of the new-Keynesians.

First; as you point out in your post, I have been working on a new generation of co-ordination failure models in which a high unemployment equilibrium can persist forever. The clearest exposition of these models is here

http://www.rogerfarmer.com/NewWeb/PdfFiles/fa-con-cra.pdf

I call these, second generation coordination failure models. They are different from the first generation models that Stephen refers to (for example, Farmer-Guo (1994) JET). First generation co-ordination failure models have multiple non-stationary equilibrium paths all converging to the same steady state. Second generation models have multiple steady state equilibria. This is a significant difference since first generation models, like new-Keynesian and classical models, cannot account for persistent high unemployment. Second generation models can.

Second; Steve is correct that I am reluctant to support large fiscal stimulus programs. I have written two papers on the role of fiscal stimulus in second-generation co-ordination failure models, one in an overlapping generations model here

http://www.rogerfarmer.com/NewWeb/PdfFiles/Farmer_Roger_Carnegie.pdf

and a second paper joint with Dmitry Plotnikov, in a representative agent framework here

http://www.rogerfarmer.com/NewWeb/PdfFiles/Farmer-Plotnikov.pdf

In both of these models, a fiscal stimulus will decrease unemployment. But if confidence remains low, the fix will be temporary. In both models, the fiscal stimulus reduces welfare because it crowds out private consumption.

Recall that in Keynesian models, increased government expenditure is supposed to "crowd in" private consumption. That is the whole idea behind the consumption-income multiplier. My reading of the evidence is that "crowding in" (an increase in consumption caused by an increase in government purchases) is not supported by the data.

If fiscal stimulus is to have a permanent effect in the models I work with, it must work through a non-economic mechanism. One channel would be a temporary boost to employment that restores the confidence of the private sector by influencing market psychology: A confidence booster. That is a possibility. But I think it is implausible that increased government expenditure will have that effect.

My reading of the evidence is that consumption depends primarily on wealth rather than income. That was the lesson of work by Ando and Modigliani, Modigliani, and Friedman in the 1950s. It is for that reason that I support interventions in the asset markets that try to jump-start the economy and reduce unemployment by boosting private wealth. That, in my view, is what quantitative easing has done.

Bryan Caplan pointed out a distinction between filling and priming a while back, though didn't evince any awareness of multiple-equilibrium models (he himself seems to accept sticky-wage market failure).http://econlog.econlib.org/archives/2011/09/keynesianism_vs.html

Have you seen this paper?http://ideas.repec.org/p/nbr/nberwo/17063.html

Suppose govt. normally fails to provide an efficient level of government investment (partially nonrival capital like infrastructure, etc.). Suppose that crises provide a political impetus to partially correct this govt. failure. That would make stimulus quite effective, as long as it comes in the form of govt. spending on public capital goods (also recall Baxter & King 1993).

The multiple equilibria could be political-economic equilibria related to levels of public capital investment...

Maybe we live in an economy with multiple equilibria. Maybe some recessions knock us down to a bad equilibrium. And maybe the temporary elimination of political-economic constraints on optimal public investment can knock us back to a higher equilibrium. In that sort of world, fiscal policy has both long-run and short-run ("stimulus") effects.

Given the fact that our main piece of anecdotal evidence that fiscal policy is important is war, this seems like an idea worth pursuing...

Roger says that quantitative easing jump starts the economy through wealth effects. While loose monetary policy was necessary to save the money markets it is a temporary fix. As a middle aged investor I am leery of investing in the American markets and I refuse to touch American banks precisely because the markets are so distorted by government action that no one knows what the real value of anything is. So I sold some shares, sold the long bonds, paid off the margin loan and sit on more GICs than I really want.

Stephen Williamson: "That's not quite right, at least speaking for myself. Krugman has made it quite clear that he is an IS/LM guy, though occasionally you can read multiple equilibrium reasoning into what he says. "

Question - Is the capital really just 'sitting there', or is it all wasting it's time in super-fast Investment Banking deals?

I think the money was in banking, if you look at the increase in 'skim' by financial services, you have twice as much money tied up in finance as you used to, and nobody investing in production.

I'd love to see some data on finance as a percentage of GDP and business investment over a period of years. I think the lure of over 10% return on 'crap' kept money away from firms that could have been profitable at 6% or 8% interest.

You said it's implausible that government expenditures will raise confidence in the private sector. Isn't the point of government hiring not to increase government expenditures in and of themselves, but to increase consumer spending by those employed through stimulus? If private sector confidence isn't restored by consumer purchases, what can it be restored by? Do businesses not expand in the face of increased demand because they think their customers might be temporary government employees? Do you have any data to support your conjecture?

Noah, Interesting post. I think the discussion of multiple equilibria is motivated by two distinct cases. In the early 1980s the unemployment rate in both the US and France soared to over 10%. In the US it fell quickly, and it France it stayed near 10% permanently. There are two possible explanations for this difference; multiple equilibria in France or French labor market rigidities. (My hunch is rigidities.) The next question is whether the US today is more like the US in the 1980s or France in the past 30 years. This is where I think people need to be careful. In my view the most plausible explanation is some of each, after all, the US unemployment rate does seem to be falling, but more slowly than many natural rate models would predict.

Kantoos has some interesting observations on your post. He notes that one flaw in the Keynesian model is that the same interest rate can be associated with very different demand outcomes. He suggests replacing interest rates with NGDP as both an indicator and a target of monetary policy. Interestingly, the logic he uses is also applicable to Farmer's proposal to target stock prices. NGDP (futures) targeting and stock index targeting are simply alternative ways out of the zero rate bound.